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In corporate finance, leverage, otherwise termed as debt financing, is the use of exogenous funds by corporations to run their operations smoothly and expand the same. While there is option for equity financing, if a company wants to avoid debt, historically debt financing has been preferred over equity.

Such a choice is driven by the cheap and easy availability of debt compared with equity financing. However, one should keep in mind that debt financing remains a feasible option as long as the companies succeed in generating a higher rate of return compared to the interest rate. Exorbitant debt financing might even lead to a corporation’s bankruptcy in a worst case scenario.

This is because while debt brings with it the capacity to spend a little bit more, it also carries the burden of repayment with additional interest in the future. As a result, prudent investors try to avoid companies with large debt loads since they are more vulnerable during economic downturns.

Empirically it has been found that in periods of low interest rates, debt financing has gained more traction. At present, with robust parameters supporting growth across the U.S. economy and thereby favoring interest rate hike, the market is not very attractive for hugely burdened companies. Naturally, investors would like to avoid debt ridden stocks and seek those bearing low debt levels. Debt-free stocks are, however, rare.

Therefore, to safeguard one’s portfolio from losses, an investor should prudently determine whether the stock’s debt level is sustainable. Historically, several leverage ratios have been developed to measure the amount of debt a company bears and debt-to-equity ratio is one of the most common ratios.

Analyzing Debt/Equity

Debt-to-Equity Ratio = Total Liabilities/Shareholders’ Equity

This metric is a liquidity ratio that indicates the amount of financial risk a company bears. A company with a lower debt-to-equity ratio indicates improved solvency for a company.

With the second quarter earnings season approaching, investors must be eyeing companies that exhibited solid earnings growth in the prior quarters. However, blindly pursuing high earnings yielding stocks might drain all your money before you know, especially if the stock bears a high debt-to-equity ratio.

Considering this, it will be wise for investors to select companies with low leverage. These are financially more secure and immune to financial bankruptcy.

The Winning Strategy

Considering the aforementioned factors, it is wise to choose stocks with a low debt-to-equity ratio to ensure safe returns.

However, an investment strategy based solely on the debt-to-equity ratio might not fetch the desired outcome. To choose stocks that have the potential to give you steady returns, we have expanded our screening criteria to include some other factors.

Here are the other parameters:

Debt/Equity less than X-Industry Median: Stocks that are less leveraged than their industry peers.

Current Price greater than or equal to 10: The stocks must be trading at a minimum of $10 or above.

Average 20-day Volume greater than or equal to 50000: A substantial trading volume ensures that the stock is easily tradable.

Percentage Change in EPS F(0)/F(-1) greater than X-Industry Median: Earnings growth adds to optimism, leading to a stock’s price appreciation.

VGM Score of A or B: Our research shows that stocks with a VGM Score of A or B when combined with a Zacks Rank #1 (Strong Buy) or 2 (Buy) offer the best upside potential.

Zacks Rank #1 or 2: Irrespective of market conditions, stocks with a Zacks Rank #1 (Strong Buy) or 2 (Buy) have a proven history of success.

Excluding stocks that have a negative or a zero debt-to-equity ratio, here are five of the 30 stocks that made it through the screen.

HollyFrontier Corporation (HFC - Free Report) : The company produces and markets gasoline, diesel, jet fuel, asphalt, heavy products and specialty lubricant products. It pulled off an average positive earnings surprise of 41.26% in the trailing four quarters and currently sports a Zacks Rank #1.

Amedisys Inc. (AMED - Free Report) : It provides home health and hospice services throughout the United States to the growing chronic, co-morbid and aging American population. The company sports a Zacks Rank #1 and delivered an average positive earnings surprise of 10.58% in the trailing four quarters.

MGM Growth Properties LLC (MGP - Free Report) : The company is one of the leading publicly traded real estate investment trusts engaged in the acquisition, ownership and leasing of large-scale destination entertainment and leisure resorts. It pulled off an average positive earnings surprise of 3.02% in the trailing four quarters and currently carries a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank stocks here.

Brown & Brown, Inc. (BRO - Free Report) : It offers a broad range of insurance and reinsurance products and services, as well as risk management, third party administration, managed health care, and Medicare set-aside services and programs. The company has a Zacks Rank #2 and pulled off an average positive earnings surprise of 9.53% in the trailing four quarters.

Westlake Chemical Corporation (WLK - Free Report) : It is a vertically integrated international manufacturer and supplier of petrochemicals, polymers and fabricated products. The company currently sports a Zacks Rank #1 and delivered an average positive earnings surprise of 5.86% in the trailing four quarters.

Get the rest of the stocks on the list and start putting this and other ideas to the test. It can all be done with the Research Wizard stock picking and back testing software.

The Research Wizard is a great place to begin. It's easy to use. Everything is in plain language. And it's very intuitive. Start your Research Wizard trial today. And the next time you read an economic report, open up the Research Wizard, plug your finds in, and see what gems come out.

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

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At the center of everything we do is a strong commitment to independent research and sharing its profitable discoveries with investors. This dedication to giving investors a trading advantage led to the creation of our proven Zacks Rank stock-rating system. Since 1988 it has more than doubled the S&P 500 with an average gain of +25.32% per year. These returns cover a period from January 1, 1988 through November 5, 2018. Zacks Rank stock-rating system returns are computed monthly based on the beginning of the month and end of the month Zacks Rank stock prices plus any dividends received during that particular month. A simple, equally-weighted average return of all Zacks Rank stocks is calculated to determine the monthly return. The monthly returns are then compounded to arrive at the annual return. Only Zacks Rank stocks included in Zacks hypothetical portfolios at the beginning of each month are included in the return calculations. Zacks Ranks stocks can, and often do, change throughout the month. Certain Zacks Rank stocks for which no month-end price was available, pricing information was not collected, or for certain other reasons have been excluded from these return calculations.

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